Canadian banks often receive positive press for being some of the safest banks in the world, a title that has been earned through the global financial crisis of 2008. However, as a diligent investor, it is important to realize that even well-run businesses carry risks which need to be managed on an ongoing basis.
How Banks Work
A bank is a business that essentially buys and sells money just as a clothing store buys and sells clothes. In its simplest form, a bank receives deposits from customers who would like to earn interest on their savings (i.e. savings accounts & GICs). The interest which depositors earn is the rate at which a bank “buys” its merchandise (i.e. money). The bank then takes that merchandise (the money) and “sells” (loans) the funds at a marked-up rate to people who need to borrow money (i.e. mortgages & loans). In reality, bank operations involve inter-bank lending and reserve ratios which complicate the process but the premise remains the same; banks borrow money at a rate and then lend it out at a marked-up rate to make a profit. The difference between the rate at which the bank borrows money and the greater rate they lend it out at is the spread, or as they call it in the banking industry, the net interest margin which is their profit.
A bank’s borrowing and lending rates revolve around the target overnight rate set by the governing central bank (such as the Bank of Canada). Generally, the target rate is low when the central bank wants to stimulate the economy and the target rate is higher when the central bank wants to slow down the economy (i.e. if there is a threat of inflation). While the large Canadian banks engage in more than just lending activities, such as, insurance, wealth management and investment banking, loans remain at the core of their businesses.
Headwind for Profit Growth
When it comes to a bank’s loan practices, a bank can increase its profit in two ways. First, it can increase the profit margin (net interest margin) it makes per loan, or, secondly, by increasing the volume of loans it makes. Currently, Canada is in a low interest rate environment designed to stimulate the economy (target rate is 1.0 per cent). When the target rate is low, banks aren’t able to take a very wide spread between the rate paid to obtain funds and the rate charged when loaning out funds (as seen with the low interest rate on savings accounts and the low interest rate charged on mortgages). In such an environment, banks must increase loan volume to grow their earnings. This is what has occurred recently. The issue with loan growth is that there is a limit to the amount of loans consumers can bear. The Canadian household debt-to-income level is at a record high with debt at over 165 per cent of income. At some point, Canadian consumers will reach their debt ceiling and loan growth for banks will slow. The effects of lean net interest margins will then be more visible on earnings.
Conclusion
Canadian banks are well-run businesses with healthy dividends and operate in a sector with high barriers to entry. That being said, it is important to remind investors that the Canadian bank stocks are not immune to market volatility. One simply needs to look back to 2008 to see that these stocks previously experienced an average decline of 34 per cent of their market value in one year. We don’t believe that this will happen any time soon, but we do believe many investors have become too comfortable collecting dividends and neglecting the volatility that can also come with the securities. With loan growth slowing combined with lean net interest margins, we believe the volatility of the share price for Canadian banks will be on the rise.
Kash J. Pashootan is a Vice President and Portfolio Manager with Raymond James Ltd. Information provided is not a solicitation and although obtained from sources considered reliable, is not guaranteed. The views and opinions of the author do not necessarily reflect those of Raymond James Ltd. Securities offered through Raymond James Ltd., Member-Canadian Investor Protection Fund. Insurance offered through Raymond James Financial Planning Ltd., not a Member-Canadian Investor Protection Fund. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.